The "Public-Private Investment Programme" will purchase the troubled mortgages and securities that have been at the root of the credit crunch.
The Treasury has committed $75bn to $100bn to the programme and said the private sector would also contribute.
President Barack Obama said the move was a vital step forward.
"The good news is that we have one more critical element in our recovery," he said.
"But we've still got a long way to go."
The Treasury said the plan would help the financial system recover.
US banks still hold many mortgage-related assets that they cannot value or sell.
Having so many of so-called toxic assets on their books has made them reluctant to lend, causing the financial system to freeze up, and pushing the economy further into recession.
Investors welcomed the news, with stocks rising in the US and Europe.
Detailed plan
"This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly," the Treasury said.
"Simply hoping for banks to work legacy assets off over time risks prolonging the financial crisis," it added.
The $75bn to $100bn will come from the Treasury's $700bn Troubled Asset Relief Program (Tarp), which has already been approved by Congress. This money will be used to fund the government's purchase of assets.
To encourage private investors to take part in the scheme, low-interest loans and guarantees will be offered to private investors via the Federal Reserve and the Federal Deposit Insurance Corp - a government agency that backs bank deposits.
This means that the private investors, which the US hopes will include private equity, individual investors, pension plans and insurance companies, will shoulder relatively little risk, with 93% borne by the government.
The programme initially aims to buy $500bn of toxic assets, with the potential to expand up to $1 trillion.
"Over time, by providing a market for these assets that does not now exist, this programme will help improve assets values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets," US Treasury Secretary Timothy Geithner wrote in the Wall Street Journal before the programme was officially announced.
Analysts welcomed the plan but said that a number of questions remained unanswered.
Paul Ashworth, an economist at Capital Economics, said the success of the programme depended on the willingness of private investors to take part.
"And, just as importantly, the willingness of the owners of these distressed securities and loans to sell at the price that investors are ready to pay," he added.
Alternative approach
 | HOW ASSETS BECAME TOXIC Banks own large amount of US mortgages or complex financial instruments (securities) based on US mortgages Due to the bursting of the US housing bubble in 2007, many of the loans are very unlikely to be paid back by borrowers Investors desperately try to sell-off mortgages and mortgage-backed securities But as prices decline and investors realise the risk, potential buyers disappear, causing the market for these assets to seize up Wider impact: Banks stop lending to each other because their assets are worth less so they can't afford to do deals, and because the lack of clarity about value of these assets causes crisis of confidence Government plan aims to kick-start the market for these mortgage-related assets and get the wider financial system working |
Mr Geithner added that the plan was needed because the US financial system as a whole was "still working against recovery" and "many banks, still burdened by bad lending decisions, are holding back on providing credit".
He said that encouraging the private sector to take part would be better for the taxpayer as the risks of purchasing toxic assets would be shared.
BBC business editor Robert Peston said the aim of the plan is to remove as many bad assets as possible from banks' balance sheets.
This should mean that banks become less anxious about future write-offs and become more confident that they have the capital resources to re-start lending.
It is an alternative approach to that taken by the UK Treasury, which has used taxpayers' money to insure Royal Bank of Scotland and Lloyds Banking Group against future losses on some £600bn of poor loans and investments, he added.
Stocks rise
The markets have been eagerly awaiting the details of the US plan to tackle bank's toxic assets, which have been seen as a drag on world recovery.
Stocks rose worldwide on hopes that the plan would go some way to cleaning up the world financial system. The FTSE 100 of leading UK shares was up 2.4%, or 42.31 points, at 3885.16.
In New York, the Dow Jones industrial average rallied 3.8% to 7,553.8 points.
The price of crude oil also hit its highest in almost four months at close to $53 a barrel on optimism the plan would help the US climb out of recession.
The plan was originally announced in February, shortly after Mr Geithner took up his post as Treasury Secretary but details were scant on how it would work.
The Bush administration abandoned its earlier plans to buy up toxic assets in October 2008, and decided instead to use funds from the Tarp programme to take stakes in banks.
